Cover Story

Can KKR Make Like Berkshire Hathaway?

It's difficult to believe that Henry Kravis could suffer from portfolio envy. The private equity titan and co-founder of Kohlberg Kravis Roberts (KFN) is famous for his ability to buy and sell companies for profit. It's a skill that has made him enormously wealthy over his 33 years at KKR's helm: Kravis, 65, is worth an estimated $3.8 billion, according to Forbes. His firm owns or holds stakes in 51 companies with combined annual revenues of $218 billion—more than double that of private equity rivals Blackstone (BX) and the Carlyle Group. Among KKR's big-name holdings: retailer Toys "R" Us, research firm Nielsen, and hospital giant HCA.

Yet as he sits in his sparsely decorated office overlooking the south end of New York's Central Park, Kravis' thoughts drift west, to Omaha, the home of financial conglomerate Berkshire Hathaway (BRK.A). "He can make any kind of investment he wants," Kravis says of Berkshire CEO Warren Buffett, the object of his admiration. "And he never has to raise money." Kravis thinks Berkshire, with its piles of cash and trove of publicly traded shares with which to make acquisitions, is nothing less than "the perfect private equity model."

What Kravis and co-founder George Roberts, 66, covet most is Buffett's ability to pounce on deals of all sizes in any economic environment. "He has certain advantages over us," says Kravis. "I would like to see us create those advantages for ourselves."

That the storied dealmakers at KKR are acknowledging their shortcomings says much about the state of the leveraged buyout business. There was a time when private equity firms could easily collect money from investors, borrow more from banks, use the cash to buy companies, rejigger their finances, and then sell or take them public for a quick profit. When banks stopped lending in 2007 the dealmaking ground to a halt, and firms were left holding a slew of overleveraged companies they couldn't unload. All told, 543 private-equity-owned companies in the U.S. have gone bankrupt in the past two years, according to Capital IQ (MHP)—including two of KKR's: real estate lender Capmark Financial Group and doormaker Masonite. As a result, KKR's returns have suffered.

Kravis and Roberts could try to wait out the rough patch, nursing their wounds and promising investors they'll do better once the deal environment improves. Instead they're reshaping KKR's three-decade-old playbook. The financial crisis has taught the granddaddies of private equity many things. They must be nimbler and quicker. They must move beyond the audacious leveraged buyouts that have come to define private equity in the popular imagination—most famously, their 1989 acquisition of RJR Nabisco. They can't rely solely on debt to pay for their deals. They need, as Kravis puts it, "more control over our destiny."

The two have cooked up a four-part plan to make it happen. First, they're building an in-house investment bank to serve KKR's portfolio companies. Second, they're taking KKR public, with shares expected to be on the New York Stock Exchange (NYX) in early 2010, in hopes of one day using the newly minted stock to make acquisitions and invest in the firm. (It listed 30% of KKR in Amsterdam in October.) Third, while Kravis and Roberts certainly aren't abandoning buyouts, they're placing more emphasis on minority stakes and joint ventures with companies in a broader array of sectors. Finally, they're adopting new management techniques to preserve KKR's tight-knit culture as the company expands.

Other private equity firms see the value in KKR's emulating Buffett. "This makes sense for them," says John Canning, chairman of buyout shop Madison Dearborn Partners. "A firm that big can't rely [solely] on historical methods of capital raising anymore. Things change." If Kravis and Roberts get this experiment right, their strategy could point the way for other buyout firms. Even bankers acknowledge the need for firms to move beyond leveraged deals. "Private equity will become broader and broader," predicts Morgan Stanley CEO John J. Mack. "Instead of buying companies and restructuring them, they will have a whole panoply of investments."

Of course, KKR isn't alone among buyout shops in wanting to tap the public markets. Blackstone and Fortress Investment Group (FIG) got a head start, selling shares in 2007. But the financial crisis was cruel to their stocks: Even after a recent rally, they're down 57% and 79%, respectively, since their debuts.

KKR, in contrast, is going public at a time when the markets are on the mend. Call it patience or dumb luck, either way it could pay off. Since bottoming in March, Blackstone shares are up 245%, while Fortress' stock has jumped 272%. "These stocks were decidedly out of favor," says Michael Holland, chairman of Holland & Co., a New York investment firm. "But smart money that went in over the last several months has done very well."

ANSWERING TO MANYKravis is the first to say KKR will never become Berkshire East. After all, Berkshire's source of strength is its 32-year-old insurance business, which boasts an estimated $110 billion in assets, something KKR can't easily whip up for itself. What's more, Buffett built Berkshire over many decades using equity, not just debt, to buy companies. Kravis is just now venturing down that path.

There are more immediate challenges. Once KKR goes public, it will face intense scrutiny from many quarters. "Going public makes the firm accountable to many groups—the SEC, stockholders, and the exchanges," warns Edwin Burton, a trustee for the Virginia Retirement System. Adds Charles R. Schwab, founder and chairman of Charles Schwab Corp. and a longtime friend of Roberts: "I told George to think long and hard about jumping into the fish bowl."

As KKR polishes its investor-relations skills it must be careful not to alienate the pension funds, university endowments, and other wealthy investors who put money directly into KKR's buyout funds and are increasingly sensitive to fees. They pay KKR a hefty management fee of 1.5% or more of their assets and 20% of the profits. For that they expect the firm to concentrate on selling companies—not on branching out into new businesses. "We're trying to take a long, hard look at fees across the board and make sure they're justified," says Jay Fewel, a senior investment officer at the Oregon State Treasury, one of KKR's investors.

There's also a danger that, as KKR expands, Kravis and Roberts could lose focus on its main business. "The more you scale an organization, the less impact key individuals have on investment decisions," says Jeff Ennis, chief investment officer at Wilshire Associates. Already there's reason for concern. Fitch Ratings issued a report in October warning that six companies in which KKR has invested—Energy Future Holdings, HCA, First Data, Toys "R" Us, Nielsen, and Sungard Data Systems—could soon face trouble repaying their debt, though Kravis says the worries are overblown.

LBO VETSOn a dreary Wednesday in October at KKR headquarters in New York, Kravis, in a crisp white shirt and blue tie, is leading a meeting of KKR's portfolio management committee, with Roberts joining by videoconference from KKR's Menlo Park (Calif.) office. Their close relationship has been a key to KKR's success over the years. The cousins played together as kids and studied at the same college, Claremont McKenna in Southern California. After going their separate ways for graduate school they reconnected at Bear Stearns, where they worked on some of Wall Street's first leveraged buyouts. In 1976 both left Bear to form KKR with colleague Jerome Kohlberg. (He quit KKR in 1987 at age 61.) Decades of mind-melding have left Kravis and Roberts able to finish each other's sentences, a feat they perform often. When Roberts visits KKR's New York headquarters, he dips into the stash of Toblerone chocolate, jelly beans, and caramel Nips in the top drawer of Kravis' desk. Kravis says the last time the two disagreed with each other was when they fought over a bicycle—in 1951.

But Kravis and Roberts don't dominate KKR's internal operations as they once did. While the two say they have no intention of retiring soon, they're handing more authority to the firm's other senior executives. During the portfolio committee meeting, the people with the most questions aren't Kravis or Roberts but members of KKR's senior adviser group—21 current and former corporate executives whom KKR pays to dispense wisdom on matters of strategy, investing, and management. Among them: former CEOs George M. C. Fisher of Eastman Kodak (EK), Lee Raymond of ExxonMobil (XOM), and Joe Forehand of Accenture.

Even the look of the place has changed. A few years ago, Kravis and Roberts ditched KKR's collection of classic 19th century English paintings and early 20th century American art and replaced them with abstract modern pieces. Huge, black tribal masks now dominate the New York headquarters, while bold fluorescent light fixtures stand out in Menlo Park. "At first, a lot of people hated it," Roberts says.

Kravis and Roberts say they hoped the visual stimulation would inspire their staff to think creatively. Rivals like Blackstone and Carlyle were racing ahead in building out new businesses such as hedge funds and venture funds, and were planting flags around the globe. KKR wanted its troops to dream up ways it could diversify.

KKR's makeover began in 2006 when Kravis, Roberts, and partner Scott C. Nuttall decided to act on one of those new ideas: to create an in-house financial services operation. Wall Street investment banks were beginning to launch private equity funds, but no big buyout firm had tried to provide its own financing. KKR recruited Craig J. Farr, a managing director in the capital markets at Citigroup (C), to build the group. Farr's job was to establish a business from scratch that could secure financing for buyouts, refinance companies while they were in KKR's possession, and then help take those companies public when KKR was ready to sell. He didn't seek to have it join Goldman Sachs (GS) and Morgan Stanley among the world's full-fledged investment banks. Instead, his goal was merely to serve the companies KKR controlled so it could get better terms on loans and keep some of the fees it was paying to bankers.

The idea wasn't an easy sell among KKR's dealmakers, who had strong relationships with big banks. Farr says he would get calls from Goldman about KKR deals he wasn't aware of. He had to convince his colleagues that his group wouldn't interfere with their projects, and told them they could still reach out to outside bankers; he just wanted to be part of the process. The ice thawed only after Kravis and Roberts mandated that everyone start using the group extensively.

With the disappearance of major players like Merrill Lynch (MER), Bear Stearns, and Lehman Brothers in 2008, KKR suddenly had an opportunity to pounce. As rivals were wriggling out of loan commitments, "the downturn helped us," says Farr.

STREET CRED ON THE LINEIn November, Farr's team reached a milestone when it served as lead underwriter of an IPO for the first time. The process wasn't as smooth as Farr would have hoped. Back in August, Farr and two members of his 15-person group pitched Dollar General (DG), one of KKR's holdings, to be one of the lead underwriters in its upcoming IPO. Farr promised the white-glove treatment of a boutique firm, and suggested the big banks would view Dollar General as just another transaction. It didn't hurt that KKR owned the company. Dollar General signed on, and Farr's team got to work on the deal. Among other things, Farr's team arranged for Fidelity and Sanford C. Bernstein to distribute the shares to their customers.

But by October the deal was in trouble. The stock market began to slump, and IPOs were performing poorly. KKR insiders feared the Dollar General deal would flop, too. Kravis and Roberts started e-mailing and calling Farr daily to emphasize what he already knew: The offering had to succeed. KKR's Street cred was on the line. "There was a lot of pressure," says Farr.

As the Nov. 12 IPO approached, Farr scrambled. He put two senior members of KKR's deal team on the phone with investors to answer any questions they might have and sussed out which potential investors were likely to hold the stock for a long time and which weren't. The last-minute push worked: General's stock priced within the range KKR had promised and rose 8.2% during its first day in trading. Dollar General raised $716 million. KKR pocketed $10 million as one of three lead underwriters, alongside Goldman and Citigroup.

Farr's team has served KKR's buyout funds in other ways recently. In July, when outside banks weren't lending, it arranged the loans and debt for KKR to buy the South Korean unit of Anheuscher Busch InBev for $1.8 billion. And it rounded up investors for a significant portion of the debt needed to pull off KKR's Nov. 8 purchase of a Northrop Grumman consulting division for $1.65 billion, with partner General Atlantic. One of the investors was KKR's $13 billion debt fund.

WHAT WILL THE PROS SAY?Buffett, who declined to comment for this article, has little affection for private equity. He blasted the industry in his annual shareholders' letter in March, accusing it of piling debt on companies and burdening them with enormous fees. Whereas Berkshire has just $38 billion of debt spread across 76 companies, according to data compiled by Bloomberg, KKR's 51 companies carry at least $170 billion.

One of the reasons Kravis wants to take KKR public is so that he, like Buffett, can use his stock as a tool to buy companies, or slivers of them. Shareholders give Buffett so much lattitude to buy companies in part because he has delivered strong results for them for decades. Kravis wants that kind of freedom, too. "We're not just a private equity firm," says Kravis. "We're an asset management firm....If all you're going to do is say you'll buy 100% of companies, you're passing up a lot of opportunities where you can make a lot of money."

Perhaps, but some of the professional investors who put money into KKR funds expecting it to buy and sell companies aren't keen on KKR's taking too many minority investments in public companies, like an ordinary mutual fund. "I'm not opposed" to those deals, says Mario Giannini, CEO of KKR investor Hamilton Lane. "But if there are a lot of them, you have to question if you're paying private equity fees for public equity investing." In that sense, Buffett's "perfect private equity model," in Kravis' words, doesn't fully translate to KKR.

One transaction from September illustrates how KKR can play an active role in managing companies even when it doesn't take full control of them. Early in the year two members of KKR's tech group, Herald Y. Chen and Adam H. Clammer, pitched their bosses on an investment in Eastman Kodak. The two had examined taking Kodak private on numerous occasions over the last decade, but for one reason or another it never came to pass. This time both parties were willing to explore all options. Kodak needed cash to expand its ink-jet printer business for retail consumers as well as its commercial printing and scanning businesses. But with the debt markets frozen at the start of 2009, Kodak couldn't raise money cheaply by issuing bonds or taking out loans. It began kicking around the idea of selling a stake instead. For KKR, this presented an opportunity for a new kind of dealmaking: Instead of taking over Kodak outright, it could become a partner.

Chen and Clammer performed due diligence for six months, talking extensively with Farr's capital markets group about how to structure a deal amid such volatile markets. They also reached out to KKR's in-house team of operational executives who parachute into companies to turn them around. And they talked with Fisher, the former Kodak CEO who now works for KKR, about how Kodak's operations could be improved.

As the two sides examined the numbers, Kodak's current CEO, Antonio M. Perez, visited Kravis in New York and Roberts in California. He wanted to know whether they shared his view that Kodak's stock was undervalued and whether they intended to be long-term shareholders. Kravis and Roberts convinced him of both. "That was the key," Perez says. "They believed in the value-creation opportunity we thought we had."

KKR also sold Perez on the potential for Kodak to tap its 51 companies as customers and suppliers. The two sides agreed that KKR would take two seats on Kodak's board and that KKR would deploy its in-house managers to work on new growth opportunities. An hour after the deal closed on Sept. 16, Kodak formed the "K Squared" team, which consists of seven Kodak executives and six KKR operational executives. The group, which meets monthly, aims to find ways Kodak can sell more to KKR's companies, ramp up its sales force, and make acquisitions. Since the deal closed, at least six KKR-owned companies have gotten involved in dialogues with Kodak about how they can work together.

K-Squared hasn't been around long enough to affect Kodak's quarterly profit results. Investors, though, don't seem optimistic. Kodak's long-suffering share price has fallen by 36% since the deal closed. "It's a long-term investment," says Kravis. "We got involved in this because we knew it was a turnaround."

CORE VALUES AND LONGEVITYFor Kravis and Roberts, the biggest challenges in remaking their company may be internal. They'll have to figure out on the fly how to grow quickly without falling prey to Big Company syndrome. With headcount having tripled since 2004, from 204 people to 637, Kravis and Roberts fear KKR could become siloed and bureaucratic. The two now consult regularly with senior adviser Rajat K. Gupta, a former global managing director at McKinsey & Co., for thoughts on the best way to manage the expansion. Gupta saw similar growth at McKinsey: The firm's professional staff grew from 500 to 9,000 during his 35-year tenure there. "The vision," says Gupta, "is to develop a premier global institution for alternative investments."

More than anything, Kravis and Roberts want to create a mature, meritocratic company that will long outlast them. To drive that point home, the two have begun tying part of KKR compensation to how much an executive takes advantage of all the firm's new capabilities.

But Gupta has pressed them to do more, sometimes veering into touchy-feely territory. In May, at Gupta's urging, KKR partners and managing directors from around the world gathered in New York to talk about how they were adhering to the firm's "core values" (integrity, respect, teamwork, excellence, innovation, accountability, fortitude, and sharing). There were no "trust falls" during the four-hour meeting at the New York Sheraton Hotel and Towers, but between bites of deli sandwiches the team discussed how they could improve the way KKR is carrying out its new mission and improve its internal and external communication. Another Gupta idea: As part of the annual 360-degree performance-review process, 12 partners now must conduct in-depth interviews of 72 executives at the firm.

These sorts of things don't seem like the province of buyout barons. Then again, what choice do Kravis and Roberts have when the rules of the game have changed? Loading mounds of debt on a company in hopes of selling it later for a big profit is a technique befitting a "cave man," says Kravis. "The days are long gone when you just buy a company and hope that financial engineering will work. Our job today is to create value. Private equity, to me, is acting and thinking like an industrialist."